Simon Jessop and Tommy Wilkes by Tim Hepher

LONDON/PARIS (Reuters – The growing numbers of Europe’s socially conscious investors have largely ignored defence firms, but they now see a chance to make a case for a space in portfolios.

A single asset manager said last week it would allow defense investment again. It is an indication that widespread resistance to the ownership of defence companies by sustainable investors in Europe has begun.

Analysts predict that more will follow. It will be difficult for those with a sustainable mindset, which is defined as investing in businesses that have an impact on the world.

Rolls Royce, Thales and Airbus joined a group of companies calling on investors over the past two weeks to give the sector more favoritism. They argue that security and stability is key to long-term sustainability.

After a year-long lobbying effort by the sector to convince European authorities that defence should not be excluded from the framework for socially responsible investments, this decision comes just after the European Commission approved a “taxonomy” for future defense funding.

This follows years of European investors avoiding the sector to favor firms with strong environmental, social, and governance profiles (ESG), which has hurt defense shares and raised financing costs.

Reuters reported that most funds that are concerned with sustainability have not yet made a decision to spend on defense. Some are however looking at the potential returns from regional efforts to increase security spending.

Sweden’s SEB Investment Management said last week that they had lifted the blanket ban against any company derived more than 5 percent of their revenue from defense. Six of six SEB funds were affected, but most of its product portfolio remains unchanged.

SEB said that the Russian troops gathered at the Ukraine border were the reason for the shift. This underscores the fact that both clients and fund houses have to answer for their sustainability promises.

Luke Sussams (head of ESG Europe, Middle East, and Africa at Jefferies) stated that there is evidence of many large European asset managers reevaluating the sector. ESG investors have been awakened by the conflict in Ukraine and Russia.

Some others argue that sudden changes in Europe’s security architecture do not indicate that fighters, missiles or tanks can suddenly be sustained.

“Sustainable investments must fulfil the criterion “Do no significant harm” – this is not the case with armaments,” said Henrik Pontzen, head of ESG at Union Investment. Any company earning more than 5% from arms sales will be excluded from the sustainable funds.

Sasja Beslik is the head of sustainability for PFA Danish Pension Fund. She said that investors are wrong if they believe they can ensure investments in defense go only towards protecting borders.

“What will we include tomorrow?” We should include chemicals companies polluting some parts of the globe, but not all. He told Reuters that it was absurd.

Funds with an explicit sustainable or ethical mandate might find it difficult to alter their stance, but funds that have a more loose requirement to integrate ESG risk may be more flexible.

Businesses that generate more than 5% of their revenue through defense usually don’t make sense for sustainable managers. The vast majority of risk-focused fund administrators ban businesses involved in unconventional weapons, such as cluster munitions.

UBS analysts observed that ESG managers would rather engage than be exclusionary.

Morningstar reports that sustainable funds are 0.2% more inclined to defense and aerospace than the Vanguard Total World Stock ETF, which is 1.1%. Europe’s underweighting ratio is 0.2% to 1.6%.

SOCIALLY GOOD or BAD?

However, the defence lobbyists feel they are winning, especially since there is strong evidence that Europe’s push to encourage investment in social and environmental friendly activities does not exclude them.

The European Commission’s ‘Social Taxonomy Report’ was prepared last month. It did not include a reference to defense as being socially detrimental. It was feared by lobbyists that it might lead to fund exclusions.

As Germany and Sweden announce higher defense spending after the War in Ukraine, analysts rush to improve forecasts, and shares have rocketed.

Agency Partners condemned ESG concerns as “spurious, morally weak”, stating in a note that EU taxonomy had hampered the value and investability of defense stocks.

French warplane manufacturer Dassault Aviation lashed out at the “schizophrenic” situation where European defence spending was only increasing for U.S. competitors to profit, as European suppliers were being hurt by EU taxonomy drives.

Eric Trappier (CEO) said that taxonomy was not an effective weapon to combat current threats. He also represented the French defense industry. It is used against us as the defense industry. The proof of this is that small suppliers to the sector are having problems with their banks.

FIGHTBACK

But, it isn’t over for the defense industry.

Hortense BIOY, sustainability director at Morningstar said that including defence in EU social’s taxonomy will “fly in front of the ‘Do No Significant Harm principle’”.

European technical experts are supporting a 5% threshold for defense companies to be excluded from the EU’s proposed ‘EU Ecolabel. It is designed to allow consumers to find more eco-friendly and socially responsible products.

According to a spokesperson, the Commission will “carefully consider all the implications that those exclusions have on defence-related activity”, although no final decision was made.

A fragmented market that is unable to compete with competitors in the United States, where ESG concerns have less widespread prevalence, it’s crucial for investors to attract their attention.

Jan Pie (secretary general for the European defense industry lobby ASD) stated, “Even though some banks and investors may be coming back to defense it does not necessarily mean that all of them are,” adding that more stable financial backers were needed in order to sustain long term defence.

Public opinion shouldn’t decide whether the defense industry should be funded.